Risk management is critical when trading stocks and options. Managing risk involves a variety of strategies that can help you protect your portfolio.
There is no "one-size-fits-all" solution. Each trader must assess his or her own risk tolerance and develop a strategy for their goals and preferences.
The key is always knowing your exposure and having a plan. Start by assessing your risk tolerance level, which is the amount of risk you are willing to take an a position or as a whole portfolio. This can vary by time horizon and your financial situation.
Once you know the level of risk you are comfortable with, you can develop a strategy to quantify and assess your overall risk exposure, limit your losses, and protect your profits.
Position sizing is the practice of carefully determining asset allocation, risk-reward ratio, market conditions, and profit goals. It often involves only risking a percentage of an account's equity on any one position.
Hedging includes offsetting positions in different assets in order to reduce risk exposure. Portfolio hedging enables you to protect your existing investment positions by opening alternative positions that offset other losses.
For example, a trader who is long a stock may buy put options on the same stock.
Risk management is the process of protecting investments through calculated position sizing, hedging, and diversification. Traders and investors must continually assess risk and strategize how to manage the inherent risk that exists for all financial instruments.
Why is risk management important?
Risk management is essential to long-term success in investing. All investing includes risk; to persist, traders and investors must identify, quantify, and mitigate risk responsibly.